Academic journal article Journal of Risk and Insurance

Market Risk, Interest Rate Risk, and Interdependencies in Insurer Stock Returns" a System-GARCH Model

Academic journal article Journal of Risk and Insurance

Market Risk, Interest Rate Risk, and Interdependencies in Insurer Stock Returns" a System-GARCH Model

Article excerpt

ABSTRACT

We examine market risk, interest rate risk, and interdependencies in returns and return volatilities across three insurer segments within a System-GARCH framework. Three main results are obtained: market risk is greatest for accident and health (A&H) insurers, followed by life (Life) and property and casualty (P&C) insurers; interest rate sensitivity is negative and greatest for Life insurers; and interdependencies in returns are significant with the magnitude being strongest between P&C and A&H insurers. The implication is that greatest diversification benefits arise between Life and the other segments of the insurance industry. Market risk and interest rate risk for diversified firms are smaller than those for nondiversified firms for both product and geographic diversification.

INTRODUCTION

The literature on the stock return behavior of banks and insurers demonstrates that these institutions are exposed to time-varying market and interest rate risks (Brewer et al., 2007). In examining risk-return relationships for insurers, Staking and Babbel (1995) identify a trade-off between the increasing probability of financial distress and the tax benefits due to leverage, and another trade-off between protecting franchise value and the expropriation of value through increases in exposure to interest rate risk. Through these trade-offs, the authors show why "insurers manage both capital structure (leverage) and interest rate risk (surplus duration) as part of their effort to maximize value" (p. 711).

In addition to research that has examined market and interest rate risks, interdependencies (spillover effects) of stock returns within the banking sector or across the banking and insurance sectors have received considerable attention (e.g., Elyasiani et al., 2007). However, the literature does not provide a direct comparison of interest rate risk between property and casualty (P&C), accident and health (A&H), and life (Life) insurers within the same analytical framework, and fails to examine the direction and the magnitude of the spillover effects across these three insurance sectors. This study provides the first examination of market risks, interest rate sensitivities, and interdependencies in stock returns across the P&C, A&H, and Life segments of the insurance industry for a common time period, in the aggregate as well as disaggregated small and large size, and diversified and nondiversified insurers.

Intraindustry spillovers or interdependencies constitute an important question for regulators, insurer managers, and investors. Just as bank regulators are concerned with bank runs and possible contagion effects, insurance regulators are interested in intersectoral interdependencies because shocks to one sector may be transmitted to other sectors, resulting in the collapse of the entire industry. (1) Insurer decisions concerning the optimal avenue for product diversification through acquisition are also dependent on the extent of interdependence among different sectors of the industry; the more strongly these sectors move together, the smaller the diversification gains will be. This issue has implications on insurer decisions for entering single versus multiple lines of insurance activity and mergers and acquisitions across these lines. Similarly, from the viewpoint of investors in insurer stocks, high interdependence among different segments of the industry will translate into small gains in terms of risk diversification.

As De Nicola and Kwast (2002) have discussed, interdependencies may be direct or indirect. Direct interdependencies may arise, e.g., through counterparty credit exposures on derivative instruments such as futures, options, and swaps. Indirect interdependencies arise from exposures to the same or similar assets, and from other sources such as underwriting similar types of events. Common positions in these instruments can tie different segments of the insurance industry to a common fate. …

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